A BRIC You Can’t Build With, A Ship That Won’t Sink

The month of August has so far been a repeated drumming for global markets. Falling oil prices, the devalued yuan and a collapsing Chinese stock market have people running scared, and if we’re totally honest it’s probably too soon to know what it really happening as easily panicked sellers jump the gun.

bricInstead I’d like to take a moment to reflect on the fall of the BRICs, the supposed new economies of the developing world. Back  in 2003, two Goldman Sachs analysts wrote a paper called “Dreaming With BRICs: The Path to 2050” which made a convincing case that Brazil, Russia, India and China would grow substantially over the next half century. For a while that seemed true, and the few BRIC mutual funds available returned solid results to investors who bought the BRIC story.

Today much of that story sits in tatters. Russia is more regional gangster than growing economic power, a victim of its own pointless efforts to reestablish hegemonic influence and maybe even undo NATO. Brazil is a longer story, but financial mismanagement has largely undermined Brazil’s early 21st century economic kick start, leaving interest rates too high and an economy on a path to recession. India is perhaps the only country that sits separate from this mess, but as a democracy (one mired in corruption no less) it’s own worst enemy is often protectionist populism that threatens to undo it’s own promise.

Yes, I have managed to shoehorn this image into my article. Have you watched this movie recently? Me neither. I haven't missed it either.
Yes, I have managed to shoehorn this image into my article. Have you watched this movie recently? Me neither. I haven’t missed it either.

But with the Chinese economy heading for what looks to be a potentially prolonged slow down (or worse) it seems safe to say that we’ve lost the path to 2050 and aren’t in danger of finding it anytime soon. This is a useful reminder that predictions about the futures of markets, no matter how grounded in math they may be, are in fact almost always misguided. That may seem obvious with much of the recent history a testament to predictions gone wrong, but it is surprisingly easy to be sold on investment ideas that seem to be an inevitable certainty.

There are a multitude of reasons for this, not the least of which is the human defect to see patterns in randomness. Attempts to control and manage huge events; to understand, tame and control random elements of nature is the underpinning of almost every story of hubristic arrogance that leads to tragedy, both literary and literal. Whether we are watching a history of the Titanic, or Alan Greenspan testifying to the benefits of derivative markets, there is always an iceberg somewhere threatening to make a mockery of our certainty.

This is what travelling the ocean was frequently like in history. Had we waited until we had an unsinkable boat we would never have sailed anywhere.
This is what travelling the ocean was frequently like in history. Had we waited until we had an unsinkable boat we would never have sailed anywhere.

I’m of the opinion that there may be somethings simply to complex to be fully understood. That shouldn’t mean we shy away from complicated markets, rather we should be mindful about the risks of participating. After all, the Titanic sunk largely as a result of the assumption it could not. But people had been sailing across the ocean for centuries with considerably greater danger. That’s a useful reminder about investing. Good investment strategies don’t seek out perfect investments, ones that cannot be undone by bad markets, instead they assume that markets are filled with risks and aim to navigate the dangers.

Russia’s Entire Stock Market is Worth Less Than Apple Computers

Let's just call this what it is. Awkward.
Let’s just call this what it is. Awkward.

A few days ago a bizarre inversion took place. A single company was suddenly worth more than the entire investable market size of a major economy. While I like Apple a lot and applaud the incredible profitability of the company, this is more a story about how badly the Russian economy is doing.

Back when Russia was first inciting dissent inside the Ukraine following the ouster of the quasi-dictator running the country, it had banked on the idea that it’s continued escalation inside the borders of a sovereign nation would go unchallenged as few countries would wish to risk a military skirmish over a single, marginal country in Europe.

Vladimir Putin miscalculated however when he didn’t realize how precarious the Russian economy was. Sanctions were implemented and what followed was a largely hollow trade war that did more to identify Russia’s weakness than strength. But the most recent blow to Russia has been the change in the price of oil.

Screen Shot 2014-11-21 at 12.31.04 PMNow that the price of oil is under $80, Russia is suffering severely. Like many oil rich nations, oil exports substitute for taxes. This frees autocratic rulers to both pursue generous social programs while not having to answer to citizen complaints about high taxes. It’s how countries like Saudi Arabia  and Iran get by with little democratic input and a relatively passive population with little to no public disobedience about democratic rights (mostly).

This relationship though means that there are actually two prices for oil. First the breakeven price for extracting oil from the ground, and second break breakeven social price of oil. Those prices are different in every country. In Alberta for instance, tar sand oil is usually quoted at $70 a barrel for breakeven. But to cover the costs of running the government the price is much higher. For Russia the slide in price from $109 a barrel to $80 has meant wiping out it’s current account surplus.

Combined with the falling rouble (now 30% lower than the beginning of the year) and the growth of corporate debt sector, Russia is now in a very precarious situation. I’m of the opinion that energy, and energy companies have been oversold and a rise in price would not be unexpected. But whether the price of energy will bounce back up to its earlier highs from this year seems remote.

This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It's hard to tell because he was actually paid to stand there and look like this and we can't ask him.
This is a stock photo of a guy thinking. Could he be thinking about where to invest his money? He could be. It’s hard to tell because he was actually paid to stand there and look like this and we can’t ask him.

Over the last few months I’ve been moving away from the Emerging Markets, and while the reasons are not specifically for those listed above, Russia’s problems are a good example of the choices investors face as other markets continue to improve their health. If you had a dollar today that could be invested in the either the United States or Russia, who would you choose? The adventurous might say Russia, believing they could outlast the risk. But with more Canadians approaching retirement the more sensible option is in markets like the US, where corporate health is improved, debt levels are lower and markets are not subject to the same kind of political, economic and social instability that plagues many emerging economies.